Capacity payments conundrum

The matter of increased capacity payments to power plants has sparked a heated controversy. In recent years, these payments have more than doubled, from 1,082 billion rupees to nearly 2,153 billion rupees, according to data from the electricity ministry.

The increase in capacity payment is mainly due to the rise in the dollar value from PKR 100 to PKR 300. The impact of the depreciation is seen in the per unit capacity payment, which has increased from PKR 10/unit to PKR 19/unit.

To keep their power plants operational and accessible to provide electricity at all times, including during periods of low demand, generation companies charge capacity payments as a fixed fee. These payments are crucial to the economic survival of power plants.

The citizenry, however, is increasingly worried that these payments are swallowing a more significant percentage of the country’s finances. Numerous specialists believe that the solution lies in renegotiating contracts with generation companies to reduce monthly expenses and avoid over-capacity in future. Escalating electricity costs are causing rising tensions, with IPPs being held primarily accountable.

Rather than oversimplifying the topic, adopting a balanced approach that considers all critical perspectives is essential. Only then will we be able to grasp the complicated issue of over-capacity and growing capacity payments.

Historically, the discussion has tended to be cursory, lacking a thorough evaluation of the interplay between macroeconomic variables, contractual commitments, and the difficulties of long-term generation planning. It is vital to recognise that too simplistic explanations risk ignoring crucial practical elements that control the operation of large-scale infrastructures.

When analysing the topic of capacity payments, it is helpful to draw parallels to fixed-cost frameworks that consumers encounter regularly. Numerous services in our personal lives depend on stable funding sources to operate without interruption.

Internet service providers typically charge monthly fees to maintain infrastructure and ensure network reliability. Mobile network operators also rely on steady subscription-based revenue to keep coverage that allows for continual mobile communication.

Broadcasters, such as Netflix, are another example - solid money streams from subscription fees support complicated systems delivering a variety of entertainment alternatives to homes across the globe.

There are core economic reasons why generation companies insist on capacity payments instead of energy payment models alone. The most important of these factors is the recovery of substantial up-front capital expenditures necessary to construct large-scale infrastructure projects. For IPPs, significant costs create the groundwork for plants to provide power regardless of fluctuations in short-term demand. IPPs invest billions in building facilities with capacities surpassing peak demand to ensure adequate supply even in emergencies. Recouping such major expenditures takes many years.

During cost-recovery stages, charging variable rates per unit would leave generators vulnerable to all economic shocks. The usage-based revenue stream proposed through the energy payments gives rise to uncertainty of meeting the fixed costs, debt repayments and equity return.

Multilateral development banks and commercial banks provide approximately two-thirds of the required capital for constructing these power plants. The unpredictability of debt repayment with energy payment schemes prevents these banks from financing the projects.

Similarly, the sponsors would not proceed to invest billions in an uncertain endeavour. If there is a mechanism (such as a must-run condition) that guarantees fixed cost recovery, debt payments and equity returns, it is akin to capacity payment.

By the sheer nature of infrastructure investments, generators must recover their capital expenditures, financing costs, and agreed-upon returns within realistic timeframes.

Without capacity payments that account for fixed operating demands irrespective of usage volume, IPPs would be justified in incorporating additional recovery risk premiums straight into per-unit prices.

This risk premium will undoubtedly lead to higher electricity bills to compensate for the lack of stable, guaranteed revenue streams.

Regardless of the billing method - fixed capacity fees or consumption-based charges - all system expenditures must be collected from consumers. Therefore, the question is not about total costs but their distribution over time. Mechanisms for capacity payments offer more consistent and predictable pricing throughout the year for households and businesses.

In contrast, energy-only models may see cheaper costs during off-peak seasons but greater volatility and the possibility of rate shocks when demand peaks.

Concerns about capacity payment regimes include asserting that they incentivise generation capacity above real needs. Overcapacity presents serious issues, but pinning exclusive blame on IPP contracts risks oversimplifying a complex subject.

A more rigorous approach acknowledges that generation planning results from multiple projections, ranging from short-term demand forecasting to long-term macroeconomic modelling subject to policy changes.

In the case of Pakistan, periodic shifts in sectoral priorities and regulations under successive regimes have frequently upset prior estimates of infrastructure growth, investment, and demand. The absence of a consistent strategic vision makes accurate modelling exceedingly tricky.

A simple and recent example is the IGCEP 2022-31, where generation planning is based on average GDP growth of 4.30 percent per year for the following ten years; however, the next IGCEP anticipates this value to be in the range of 3 to 4 percent per year. The generation planning was flawless, but the economic downturn invalidated the earlier planning.

Although overcapacity and growing capacity payments are reasons for concern, the challenges at hand necessitate a cautious evaluation of factual evidence instead of hasty diagnoses.

As with any large-scale infrastructure endeavour, attaining error-free generation planning across decades-long time horizons is hampered by constant changes in macroeconomic conditions and policy antecedents.

Concurrently, we must recognise that IPPs must promptly recoup their capital and financing expenses to continue incentivising vitally important power growth.

The optimum way ahead is not through retaliatory blaming but through constructive conversation between all stakeholders to balance these interests through flexible contractual frameworks responsive to emerging conditions.

Copyright Business Recorder, 2023